What Is a Passive Entity and How Do You Qualify?

A passive entity is a business classification for state tax purposes, designating a company that generates most of its income from investments rather than active operations. This status is significant in states with a franchise tax, as qualifying as a passive entity can provide an exemption from this tax. The specific rules and benefits are defined at the state level, so the criteria can differ between jurisdictions. This classification is important for investment holding companies and family partnerships whose revenue consists primarily of dividends, interest, and capital gains, as it directly impacts their state tax obligations.

Criteria for Passive Entity Qualification

Qualification as a passive entity depends on the entity’s legal structure and income sources. A primary requirement is the formation type, with only general partnerships, limited partnerships, and certain trusts being eligible. Corporations and limited liability companies (LLCs) are excluded from this classification, even if their income is entirely passive. The business must be organized as a qualifying entity for the entire accounting period on which the tax is based.

A precise income test is the central qualification requirement. At least 90% of the entity’s federal gross income for a reporting period must come from sources defined as passive by state tax code. Failure to meet this “90% rule” disqualifies the entity from the exemption for that period, and the calculation is based on federal gross income figures.

Passive income sources are explicitly defined as returns from capital rather than labor or services. Qualifying income includes:

• Dividends from stock holdings
• Interest from loans and bonds
• Gains from foreign currency exchange
• Net capital gains from the sale of assets that produce passive income
• Royalties from mineral properties, lease bonuses, and delay rental income
• Net gains from trading in regulated commodities futures

Conversely, certain income types are defined as non-passive and will prevent an entity from qualifying if they constitute more than 10% of the total. Non-qualifying income includes:

• Revenue from performing services, wages, and salaries
• Rental income
• Income from an active business operation
• Revenue from the sale of inventory or real property sold in the ordinary course of business

Primary Tax Benefit of Passive Entity Status

The primary advantage of passive entity status is a complete exemption from the state’s franchise tax. This exemption provides direct tax savings for qualifying partnerships and trusts, as they are not required to calculate or pay a tax on their revenue or net worth. This can be particularly valuable for entities holding substantial investment assets that generate significant annual income.

It is important to distinguish the state-level “passive entity” classification from the federal “passive activity” rules in Internal Revenue Code Section 469. The federal rules serve a different purpose by limiting the ability of individuals, estates, and trusts to deduct losses from passive activities against their active or portfolio income. The federal focus is on individual loss limitation, not on exempting an entity from a business-level tax.

In contrast, the state franchise tax exemption is a determination made at the entity level based on its structure and gross income. While both concepts use the term “passive,” their definitions, tests, and consequences are distinct. Therefore, qualifying for the state franchise tax exemption does not automatically affect how an owner reports the entity’s income or losses on their federal return.

Annual Filing and Reporting Obligations

A qualifying passive entity is exempt from paying franchise tax but not from annual reporting requirements. To maintain its status and good standing with the state, the entity must file specific forms each year to affirm its qualification. This involves filing a state franchise tax report, such as a Long Form or EZ Computation Report, and indicating its passive status by marking a designated box.

The annual report certifies that the entity meets the 90% passive income test for the relevant accounting period. The submission can often be completed online through the state’s tax filing portal. While no tax is due, failure to file the required report can result in penalties or the loss of good standing with the state.